California: New Darling of the Muni Market?

By Michael Aneiro

California, long the problem child of the municipal market, is suddenly enjoying an era of good feelings among bond investors.

The Golden State consistently ranks near the bottom of the 50 states in financial health as gauged by credit ratings and borrowing rates, and the annual drama of its budget process seems to repeat as an endless loop of perpetual cash shortfalls and tragicomic political impasses. But it’s the biggest state economy around and it always finds a way to muddle through.

In the past few weeks, though, California seems firmly in investors’ good graces and is distancing itself from the one state it consistently, if barely, outranks in the muni market hierarchy: Illinois. The main cause, as Kelly Nolan reports in today’s Wall Street Journal, is the election-day passage of a series of temporary tax hikes designed to patch the state’s finances, at least until the next crisis:

The difference in yield, or spread, between the debt of the two lowest-rated states has increased to its widest point since early March 2011, according to Thomson Reuters Municipal Market Data.

Last week, the yield on 30-year Illinois debt was 0.60 percentage point above that of similar California debt. As prices fall, yields rise. The higher the yield, the bigger the perceived risk. On Election Day, the spread was 0.42 percentage point. In July, it was 0.18 percentage point.

“Over the past year, California has done much more than Illinois to help its fiscal situation,” said Tom Weyl, head of municipal research at Barclays. As a consequence, “there appears to be decoupling” in the way the states’ bonds are trading.

California’s debt has rebounded so much that its yields this month fell below that of Nevada for the first time since August 2009, according to MMD.

On Nov. 6, California voters approved temporary tax increases that rating agency Standard & Poor’s estimates will boost the state’s revenue by more than $6 billion over the next several years, and the state has also passed modest pension changes this year. While the tax rise was a tough measure to accept for an already tax-burdened state, it’s made California’s bonds more appealing. .

By contrast, the story notes, Illinois has done little to address its $83 billion unfunded pension liability, while the state had roughly $6 billion in unpaid bills as of the end of September.